Tech's Uphill Battle

ROGER MCNAMEE, the long-time Silicon Valley investor, who is now launching a big, private investment fund geared to new-media called Elevation Partners -- among the other partners in the fund is Bono, the one-named singer from the rock band U2 -- asserted last week that there will be no new major waves of enterprise technology spending equivalent to the Windows, ERP software (enterprise resource planning, used for corporate management), or Y2K booms, for at least five years.

Given the lack of urgent new spending initiatives and continued corporate caution, Michael Kelly, CEO at Techtel, an Emeryville, Calif., market-research firm, asserts that tech spending by U.S. companies will grow right in line with GDP, about 4%. Not terrible, but hardly the stuff to fire the imaginations of investors.

"Buyers are buying IT only when needed and when benefit is proven and the benefit is related to current important business objectives," Kelly observed in a recent presentation on his firm's latest IT spending survey data. Kelly says companies are also trying hard not to have any excess capacity. "Investment spending is being made to keep capacity across the board as close as possible to actual demand. When the bubble burst, companies learned the hard way that profits were elusive when capacity far exceeded demand."

If anything, there is a renewed focus on returning cash to investors. Microsoft earlier this year announced a long-awaited plan on how to disburse some of its mammoth cash pile to shareholders, and opted for a big stock buyback plan, a $3 a share special dividend and a big hike in its regular payout. The move triggered intense discussion of whether Microsoft believed that its growth opportunities weren't as great as they had been in the past.

THAT DEBATE IS GOING TO HEAT UP AGAIN, now that Intel has chosen a similar path: The chip giant last week announced a plan to both double its dividend and sharply expand its stock-repurchase program. The push to pay out more cash to shareholders could strengthen with the recent passage of legislation that makes it easier for U.S. companies with big offshore subsidiaries to repatriate cash back home without significant tax consequence.

Bernstein's Zlotnikov suggests that technology stocks could be stuck in a period like 1984 to 1991, when they trailed the broad market almost every year, thanks to the struggles of what were then the tech market-cap giants, such as IBM, Digital Equipment, Hewlett-Packard and
Unisys.
Those companies, he notes, were suffering margin erosion and exhibiting "more cyclical behavior." Says Zlotnikov: "We're in a similar setting."

In some ways, Zlotnikov says, the market is experiencing a crisis of confidence in the economy's ability to create companies that can grow consistently. He notes that the premium of the Russell Growth index over the Russell Value index is the lowest in history. "We just don't have a lot of areas where investors believe in sustainability of growth," he says.

And when companies do show a pattern of strong growth -- think
Google,
or
Research in Motion
-- valuations skyrocket, leaving investors to cope with hard to justify stock prices. "There's such a paucity of growth opportunities," Zlotnikov says. "We've never been in that position before. Everything argues that we should have growth. And yet we don't have inflation or pricing power."

Of course, it would be folly to think every tech stock is going to crumble next year, or even that some can't post big gains. As Roger McNamee notes, however, it does mean that it is not a time when you want to be the "average dollar" invested in technology. The average dollar invested in tech, he thinks, could end up trailing the broad market.

Zlotnikov suggests a multi-pronged strategy. For starters, he recommends some exposure to cheap cyclical technology stocks. He includes smaller and mid-cap semiconductor equipment companies in that category. To balance that, he suggests buying larger software companies that are gaining market share, including
SAP,
Microsoft,
Veritas,Symantec,Mercury Interactive
and
Cognos.

He's also dabbling in communications equipment, where he expects some companies to benefit from spending by
SBC Communications, Verizon Communications
and other carriers to fend off encroachment onto their turf by cable companies. The regional Bells, he says, have paid down debt, piled up cash and have urgent reason to spend. Among his bets:
Lucent Technologies,Amdocs
and
Alcatel.

Berman, looking ahead to the world of "always on computing," expects to see a proliferation of new communication devices. That, he says, should boost chip production and lead to strong demand for semiconductor manufacturing capacity. So he advises buying
Taiwan Semiconductor Manufacturing
and
United Micro Electronics,
the leading contract chip makers.

For similar reasons, he's optimistic about the prospects for contract electronics manufacturers, who've suffered badly in the downturn, with severe overcapacity. In particular, he recommends
Celestica.
Other picks: cellphone maker
Nokia,
and
Teradyne,
a maker of semiconductor test-gear that has fallen out of favor with analysts as chip makers have cut back on capital expenditures in recent months.

WHILE MOST TECHNOLOGY-ORIENTED mutual funds have lost ground this year, a few have found ways to make money. Dave Carlsen, co-manager of Buffalo Science & Technology Fund, a $60 million fund based in Shawnee Mission, Kan., says his fund moved heavily into health-care stocks, where it continues to have almost half its assets. The fund's largest bet is on
FileNet,
a maker of content-management software that benefits from the growing need to track data for regulatory purposes. Carlsen says the fund also has big bets on
Cabot Microelectronics,
which makes slurries used in semiconductor wafer manufacturing, software makers
Citrix
and BEA, and a pair of tech giants that have had serious struggles this year, Intel and Nokia.

Wayne Collette and Trent Nevills, co-managers of the
Columbia Technology
fund, have taken an alternate approach, largely shunning mainstream, enterprise names in favor of niche plays where growth remains robust. The company's largest position, about 7% of the $40 million fund, is
eBay,
which has soared nearly 70% this year as a part of a broad rally in Internet shares.

Overall, though, technology investors face a brutal truth: The days of double-digit growth are over-and the stocks as a whole still trade at premium valuations. The information technology stocks in the Standard & Poor's 500 index have been trading at 20.8 times expected 2005 earnings, versus 17.1 times for the entire index. Making money in this kind of market is going to require some extremely nimble stockpicking.

Zandi figures tech investors have two ways out of the valuation conundrum. One would be a spurt in growth, perhaps by higher-than-expected corporate tech spending. The other would be a big drop in the dollar, which could make U.S. technology goods more attractive for overseas buyers.

Goldman Sachs' Sherlund says it's time to get used to a technology world that thinks as much about the global economy as it does new product cycles. To better understand this strange new world, Sherlund says he's been spending more time with Jack Kelly, a Goldman analyst who covers economically sensitive industrial stocks like
Tyco International
and
3M.

"We are subordinate to the economic cycle now, something which used to be an afterthought, because product cycles were so strong," he says. "Today, without any urgency to spend, people are looking much more at the economy. It's a mature, consolidating market. A lot of what we talk about is corporate profit growth. It's turned all of us into economists." And there can't be anything good about that.

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